The role that so-called quants play in the financial world is analogous to the role batfish play in keeping coral reefs tidy. Just as batfish do not construct the reef but are essential to its health, quants do not create the structure financial markets depend on but do preserve the conditions that make markets function. So it would be misleading to suggest that quants were responsible for this summer’s meltdown in the subprime-mortgage market or for the broader troubles that followed (see “The Blow-Up”).
The functioning of financial markets relies on the general acceptance of certain assumptions. One of the most important is that the market will not sustain an opportunity for someone to have a free lunch. That is, although arbitrage opportunities will arise, market forces will eliminate them. As Fischer Black and Myron Scholes demonstrated in 1973 with their seminal model for determining the value of a stock option, the “no arbitrage” assumption provides individuals with a rational basis for putting a fair price on a variety of financial instruments. Thus, it is essential that the assumption be correct, and an important role of the quant is to make sure that it is. By scrutinizing financial data, quants spot arbitrage opportunities and alert their employers to act before others have a chance to do the same.
Another basic assumption is that risk is necessary and even beneficial. On the other hand, investors are willing to incur risk only if it’s spread out. Insurance is the classic example of a mechanism for spreading the risk of financial disaster, but recently, investment companies have introduced much more sophisticated mechanisms. They make the risk palatable by embedding it in attractive-looking financial instruments in which it is diluted, and what remains of it is less evident. Such instruments are called derivatives, and with the help of inventive quants, the derivatives market has come to resemble a dim sum platter of enticing morsels. A further similarity is that overindulgence can cause indigestion.
Although I have had students who later thrived on Wall Street, I consider the role they play there closer to that of the sweepers who used to clear the ticker tape off the floor of the stock exchange than to that of a traditional investment banker. Most of the time, they have no idea what, if anything, is made by the companies with whose stocks they deal. Their mission is to blindly keep those stocks moving, not to pass judgment on their value, either to the buyer or to society. Thus, I find it completely appropriate that quants now prefer the euphemism “financial engineer.” They are certainly not “financial architects.” Nor are they responsible for the mess in which the financial world finds itself. Quants may have greased the rails, but others were supposed to man the brakes.
Daniel W. Stroock is a professor of mathematics at MIT.